Sunday, November 14, 2010

Why is high-growth phase of Indian economy short lived?

Ashima Goyal's article on Dyamics of Inflation and Output provides an good insight into how inflation and growth are related and what impacts them. I agree intuitively with the logic that inflation in India is supply determined while output is closely correlated to demand.

Increase in crude oil prices or monsoon failures in India, all have lead to increase in prices of products for consumers. Inflation starts to increase and Index of Industrial Production (IIP) shows a decline. At that instance RBI steps in to actively manage inflation rather than worry about fall in industrial growth. This is where political economy seems to dominate policy making rather than pure economics.

I believe something in policy-making goes wrong at times of high-growth. Else why is GDP growth not sustainable at or above 9%? Within 6 months of a high-growth phase, coupled with two or more instances of increase in interest rates by RBI, IIP begins to fall.Uncertainty with regards to monsoon adds to the volatility further.

Answers may lie in understanding the transmission of monetary policy, premised on existence of bank lending channel.